By Simon Gray – The alternative investment management industry has already had to come to terms with a wholesale shake-up in attitudes toward risk assessment and management in response to demand from investors. They are no longer willing to take on trust promises that managers are doing what they say they’re doing. In addition, investors need assurance that managers are equipped with all the tools and system necessary to protect themselves not only against the predictable volatility of markets but unlikely and improbable events too.

The about-face on the part of both private and institutional investors, many of which withdrew substantial amounts of capital from hedge funds in the last quarter of 2008 and the first half of 2009 and are only now re-entering the market in substantial numbers, has forced a reassessment of risk practices on managers themselves, as well as opening up opportunities but also challenges for providers of specialist risk tools and services, which are having to move swiftly to stay up to speed with market requirements.

Now the other shoe is dropping as regulatory changes start to catch up with developments in the marketplace. The European Union’s newly-approved Directive on Alternative Investment Fund Managers, for example, is just one of the recent initiatives that brings risk management practices into the ambit of national and supranational financial supervision.

The AIFM Directive lays down that managers’ remuneration policies and practices for staff whose professional activities have a material impact on the risk profiles of funds they manage must be “consistent with sound and effective risk management”. The directive provides for secondary legislation to specify the risk management functions that managers should employ, review procedures for those functions and how they should be separated from operational activities.

Article 11 of the directive sets out a range of detailed aspects of risk management by which managers must abide, including documentation of their due diligence processes, implementation of stress-testing procedures, and prescription of the maximum level of leverage a fund can employ, including the details of leveraging arrangements that could pose system risk or expose the fund to counterparty risk. All these aspects will be subject to the supervision of national regulators for funds domiciled, managed or marketed within the EU, with oversight from the future European Securities and Markets Authority.

In a white paper published in October entitled Managing Risk in a New World: Best Practices for Hedge Funds, Advent Software notes that changing attitudes toward risk also reflect a shift in the composition of the sector’s investor base. “The decade leading up to 2008 and 2009 saw an explosion of fund managers and assets, and a transformation in the profile of investors,” the report says.

“Once the preserve of ultra-high net worth individuals, family offices and endowments, hedge funds began to attract institutional investors such as pension funds, as well as mass affluent investors via funds of hedge funds. The new breed of investor tended to have different risk tolerances from traditional hedge fund clients. Institutional investors and fund of funds managers tended to want more insight into investment policies and performance attribution, as well as assurances that funds had adequate infrastructures to mitigate operational risk.”

At the same time, Advent argues, the broader access to hedge funds around the upper end of the retail market has been a contributing factor in the increased interest in hedge funds on the part of regulators, which previously took the view that the sophisticated investors that made up most of the market were capable of deciding on the riskiness for themselves of funds and strategies. “The mainstreaming of the customer base aroused regulatory concerns about investor protection, bringing more intense scrutiny of the sector, calls for greater transparency and the prospect of legislative action,” the report says.

This greater interest in hedge fund risks became suddenly focused by the financial crisis, despite the lack of substantial meaningful evidence that hedge funds either helped to precipitate the credit meltdown or that their subsequent struggles contributed to systemic risk. As Advent notes, “hedge funds faced not only steep declines in asset values and massive redemptions, but also bans on short selling, unprecedented counterparty failure, the collapse of markets for illiquid instruments and turmoil in the derivatives markets. Further, blatantly illegal behaviour on the part of a few tainted the reputations of many.”

Lance Smith, chief executive of Imagine Software says that while hedge fund managers are reluctant to admit that their proprietary risk management tools failed them during the crisis, they are under pressure from investors to upgrade and to be seen to do so. “Investors will not tolerate in-house systems based on spreadsheets and that sort of thing any more,” he says.

“Managers can no longer get away with saying they lost money because the model broke down and all the risk became correlated. Investors want to know what your assumptions are. They are also more comfortable with a third party providing analytics, as opposed to one of the traders or someone working for the fund. Investors are more cautious with their money now and they are liable to take it out very quickly.”

While hedge fund managers are always under pressure to achieve superior returns, Smith says, investors who have received disappointing returns through the crisis period now have a much broader list of demands. “One is a rigorous risk management methodology that is applied consistently, not just an occasional number fed to them,” he says. “They want increased transparency from their investment vehicles.”

A survey on operational risk conducted earlier this year by Advent in partnership with Beacon Consulting Group finds, not surprisingly, that hedge fund managers are braced for “more intense demands for greater transparency, improved controls and regulation” in the future. “Nearly 80 per cent of respondents to the survey reported a marked increase in operational due diligence requests over the previous year. Many firms recognise the need for more efficient and comprehensive risk management and reporting policies to meet the more stringent due diligence requirements of today’s investors.”

But the pressure to invest in improved risk management tools is not just a negative factor for managers in terms of the cost involved, but can also represent a marketing advantage. Says the report: “Forward-thinking managers also recognise that an advanced risk management infrastructure can be an important differentiator, providing them with a competitive advantage in attracting and retaining assets.”

Adds Smith: “More savvy hedge fund managers came around some time ago and realised that risk tools are not just something that will generate a number to feed to investors and keep them happy. It’s a tool to help them identify the market opportunities.”

One aspect of the crisis that was little anticipated beforehand was the challenge faced by many hedge fund managers in managing their financing, according to Liam Huxley, chief executive of Syncova, a software vendor that provides tools to managers and prime brokers designed to provide better calculation and transparency in the areas of margining and financing costs.

In the past, for the most part hedge fund managers have found it difficult to see what parts of a portfolio are using disproportionate amounts of their capital because of the way they are treated by the prime broker, Huxley argues. “If they have a portfolio with a certain prime broker that is treating a couple of trades within that portfolio very punitively, historically the hedge fund manager would not have been able to identify where the firm’s capital was being used up,” he says. “Now they can drill down and understand which particular trades are chewing up the capital. They can also compare that with other counterparties and see where they could get better treatment.”

Huxley says this offers managers not only much better control of day-to-day use of capital and the risk involved in the portfolio but enables them to stress-test the portfolio and understand the impact of shocks to the market such as the bankruptcy of Lehman Brothers in September 2008.

“What the Lehman collapse highlighted was not only a manager’s exposure to a particular counterparty, but also their overall risk if the whole market starts to drop and they start getting margin calls from all their counterparties,” he says. “Sophisticated hedge funds managers are now focused on making sure that they are not exposed to such shocks and to the risk of being forced to unwind trades to meet margin calls.”

This issue is highlighted by Smith, who says: “Even with stress-test calculations, what you may not adequately capture is the effect on liquidity. When a market gets really stormy, liquidity can rapidly dry up. It depends what you’re trading, and there’s not the same problem with currencies or listed equities, but traders of Eurobonds might suddenly find themselves faced with huge bid-ask spreads.

“The stress test may not take into account the knock-on effect of market turbulence on liquidity and what that could mean for the manager. If they hang on, the liquidity may come back eventually, but if they suffer a loss that requires them to meet a margin call, they may be forced to sell at current prices or pay dearly to buy back stocks they have shorted. But liquidity is simply not captured in a standard stress test or value at risk calculation.”